The Power of Information in Venture Capitalism

The Power of Information in Venture Capitalism

Josh Wolfe, CEO of Lux Capital, joins Michael Green of Thiel Macro to discuss the power of information asymmetry in venture capital markets. Institutions like SoftBank have been making big bets based on that information asymmetry, and appear to be cashing in for now. But Wolfe warns that the unprecedented levels of investment combined with the binary nature of success in venture capital markets could lead to unexpected losses. This clip is excerpted from a video published on Real Vision on March 15, 2019 entitled “Robotics Success and VC Madness.”

JOSH
WOLFE:
Does
it
really
matter
if
we're
negotiating
here
and
quibbling
over
$1
billion
or
$2
billion?
Well,
of
course,
it
does,
but
that
I
think
induced
a
lot
of
growth
investors
to
say,
let's
just
try
to
speculate
on
some
of
these
big
unicorns.

Going
back
7
years
or
so,
Andreessen-
who
I
think
is
a
brilliant
investor,
a
brilliant
technologist-
basically
said,
there's
only
10
companies
that
matter
in
a
given
year.
And
statistically,
that's
probably
true.
Now
knowing
which
10
is
very
hard,
but
he
said,
you
just
basically
want
to
be
in
those
companies.
And
I
that
was
a
meme
that
really
went
very
wide.
And
people
said,
okay,
well,
it
doesn't
matter
if
you
invest
in
Facebook
at
$1
billion,
or
$5
billion,
or
$10
billion
because
we're
going
to
be
hundreds
of
billions.

And
so
does
it
really
matter
if
we're
negotiating
here
and
quibbling
over
$1
billion
or
$2
billion?
Well,
of
course,
it
does,
but
that
I
think
induced
a
lot
of
growth
investors
to
say,
let's
just
try
to
speculate
on
some
of
these
big
unicorns.
And
you've
got
this
phenomenon
of
companies
that
were
pining
to
signal
that
they
were
going
to
be
that
next
Facebook
by
attaining
a
billion-dollar
valuation.
And
then
you
got
a
positive
feedback
effect
where
people
were
funding
these
things,
and
to
get
access,
would
write
a
$100
million
check
at
a
$900
million
pre.
And
they
would
own
10%
in
a
billion-dollar
valuation.

And
the
problem
for
the
early-stage
investors
and
their
limited
partners
is
they
were
getting
these
huge
markups.
And
on
paper,
it
looked
phenomenal.
And
then
they
would
go
out
and
raise
their
next
fund
and
put
it
into
more
illiquid
companies.
But
they
weren't
necessarily
getting
liquidity
on
that
billion-dollar
company.
And
you
have
started
to
see
over
the
past
3
or
4
years,
a
lot
of
these
unicorns
not
go
from
$1
billion
to
$800
million.
They've
gone
from
$1
billion
or
$2
billion
to
0.

And
so
there's
this
liquidity
trap
that
is
natural
in
markets
because
people
are
basically
taking
massive
amounts
of
capital,
which
in
the
venture
world,
there's
a
capital
structure
just
like
in
the
traditional
public
markets.
And
you
have
common
equity,
which
sits
on
the
bottom
of
the
stack,
and
then
preferred,
and
then
debt
on
top.
When
you
have
preferred
equity
of
a
size
that
is
so
large,
and
with
it,
might
have
the
classic
Carl
Icahn,
your
price,
my
terms.
So

SoftBank
would
come
in,
for
example-
we
could
talk
a
bit
about
them-
and
say,
sure,
we'll
give
you
$20
million,
and
we
want
to
own
20%
at
a
billion-dollar
valuation,
and
we
want
a
2X
or
3X
liquidation
preference.
Now,
you're
talking
about
a
payout
where
if
they
actually
got
sold
for
$1
billion,
SoftBank
is
not
getting
20%
of
that.
They're
getting
$600
million.
And
so
all
the
people
below
the
stack,
that
might
be
okay
because
you're
really
actually
getting
your
percentage
of
a
$400
million
distribution
in
a
waterfall,
but
what
if
it's
only
$400
million
or
$500
million?
You're
getting
nothing.

So
the
presence
of
SoftBank
coming
in
and
basically
said,
you
know
what?
We're
going
to
do
this
in
a
huge
way.
And
combination
of
Saudi
money,
and
others,
and
complex
debt
structure,
started
basically
becoming
in
a
relatively-
not
relatively-
in
an
absolutely
inefficient
market,
the
top-tick
price
setter.
And
suddenly,
they
were
writing
these
large
checks,
owning
very
large
pieces
of
companies
at
extraordinary
valuations,
setting
comps
that
other
people
would
reference,
while
SoftBank
just
did
that
as
though
they
would
fund
the
other.

They
would
publicly
come
out
and
do
these
Solomonic
baby
splits,
right?
We're
going
to
go
to
California
and
we're
going
to
invest
in
either
Lyft
or
Uber.
Fight
it
out
because
we're
going
to
king-make
one.
It's
my
view
that-
and
this
is
a
borderline
tinfoil
conspiracy
theory-
I
think
that
part
of
what's
going
on
is
SoftBank
is
investing
in
companies
that
they
know
that
they
will
be
able
to
inflate
the
value
of
later
on.
You
saw
this
with
We
Work.
First
investing
at
around
$10
billion
valuation,
then
$20-
basically,
pricing
up
the
deal
themselves.

And
when
you
looked
at
the
earnings
release,
either
a
quarter
or
two
ago,
most
of
the
profits
that
SoftBank
was
able
to
show
on
paper
were
from
the
write-ups
of
their
equity
holdings.
So
I
believe
that
a
lot
of
the
activity
is
done
not
just
because
they
think
they
can
make
money-
although
I'm
sure
that's
true-
but
because
they
believe
that
it
will
serve
as
collateral
against
a
massively
indebted
mothership
parent
company.
And
so
that
has
absolutely
distorted
the
venture
market.
And
we
have
warned
our
companies,
unless
you
and
we
are
getting
liquidity
in
one
of
these
monster
rounds,
you're
basically
taking
the
risk
that
you're
going
to
be
holding
zombie
shares.
And
I
think
that
there
will
be
a
rude
awakening
for
a
lot
of
people
that
that's
the
case.

Now,
it
has
attracted
other
people
who
are
providing
capital
as
alternatives
to
SoftBank.
And
so
you
have
crossover
funds
and
you
have
really
smart
groups.
We
have
Tiger-
who
has
absolutely
killed
it
in
a
really
smart
way-
Viking,
and
Coatue,
and
others
that
are
writing
$100
million
plus
checks.
They
do
have
the
public
market
savviness
and
understand
what
the
comps
are.
They
are
generally
value-add.
In
the
case
of
Auris,
all
those
groups
that
came
in
were
super
helpful.
But
it's
a
very
dangerous
phenomenon
where
you
have
huge
amounts
of
money
coming
in
at
huge
valuations
on
what
are
still
largely
unprofitable
binary
outcomes.

MICHAEL
GREEN:
Well,
so
those
companies
hit
on
two
separate
issues.
One
is
at
minimum
in
a
Minsky-type
framework,
they're
speculative
finance.
They
rely
on
the
capital
markets
remaining
open
in
order
to
cover
their
costs
and
service
their
existing
levels
of
debt.
At
worst
case
scenario,
they
have
Ponzi-like
aspects,
which
is
in
order
to
keep
going,
they
need
to
keep
raising
more
money.
The
second
component
though
that
you're
describing
when
you
talk
about
these
types
of
preference
rates
is
you're
creating
waterfall
characteristics
similar
to
a
securitized
debt
stack.

MICHAEL
GREEN:
The
structure
of
the
payout
is
very
different
depending
upon
the
underlying
outcomes.
And
pricing
that
is
really
quite
tricky.
It's
very
unclear
that
anyone
involved
is
actually
making
the
type
of
calculated
analysis
that
says,
well,
I
have
an
option
that
suddenly
has
very
different
components.

JOSH
WOLFE:
I
actually
think
that
there
is
a
very
sophisticated
step-
there's
just
three
steps.
The
first
step
is
the
finger
in
the
air.
The
second
is
to
the
tongue,
and
then
the
third
is
to
put
it
in
the
air.

MICHAEL
GREEN:
To
put
it
up,
yeah.
Yeah,
it's
a
highly
efficient
temperature
gauge.
I
think
that's
right.
And
that
would
largely
argue
that
most
of
the
participants
in
the
venture
space
are
not
by
experience
equipped
to
do
that
type
of
calculation-
understanding
the
option
components.

JOSH
WOLFE:
-I
didn't
look
at
a
single
spreadsheet-
not
a
single
one.
We
didn't
model
anything.
It
was
literally
we're
backing
a
team.
They're
developing
a
technology.
We
think
it's
going
to
be
relevant
to
this
market.
And
if
you
would've
told
me
that
it
would've
been
sold
for
$3
billion,
or
$8
billion,
or
$4
billion-
like
we
had
no
conception
of
what
that
range
could
actually
be.

MICHAEL
GREEN:
So
that's
traditional
venture
capital.
And
that's
obviously
meant
as
a
compliment.
But
when
you
start
making
an
observation
about
a
historical
distribution
of
payouts,
and
then
change
your
behavior
based
on
that
historical
distribution
of
payouts,
what
you're
actually
doing
is
changing
the
future
distribution
of
payouts-
i.e.
Marc
Andreessen's
observation
was
correct
as
it
described
the
history
of
venture
capital.
But
by
choosing
to
act
on
it
and
act
on
it
as
a
scale
enough
agent-
and
SoftBank
obviously
is
even
larger
in
this
context-
but
by
acting
on
it
as
a
scale
agent,
you've
changed
the
future
distribution.
You
won't
know
that
until
you
observe
the
outcomes.

JOSH
WOLFE:
I
think
you've
skewed
the
probabilities
lower.
Just
by
definition,
the
more
people
that
are
chasing
things,
the
greater
the
competition.
Now,
if
you
have
these
layers
in
the
public
markets
where
there
were
pools
of
capital
that
were
voracious
to
be
buyers
of
IPOs,
then
you
would
see
this
flood
of
IPOs,
like
we
saw
in
the
late
'90s
and
early
2000.
You
don't
see
that
today.
Now
for
a
variety
of
reasons,
the
narrative
is
to
stay
private
for
longer,
control.

But
I
think
you're
absolutely
right
that
by
making
the
observation
that
there's
a
handful
of
companies
that
mattered
and
the
price
that
you
paid
didn't,
it
attracted
a
flood
of
capital.
But
that
flood
of
capital,
I
believe
is
going
to
end
up
with
a
lot
of
donuts.

MICHAEL
GREEN:
I
think
that's
correct.
And
I
think
the
challenge
is
that
there
is
a
feedback
loop
as
you
go
through
that
process.
So
exactly
as
you
highlight
with
SoftBank,
where
they're
able
to
write
up
their
investments
and
show
profits,
that
in
turn
is
then
it
would
be
presented
to
investors
and
say,
hey,
look
how
stable
this
process
is
or
how
profitable
it
is.

MICHAEL
GREEN:
It's
absolutely
a
Minsky
cycle.
The
challenge
on
all
of
this
though
is
that
in
a
world
that
is
dominated
by
empirical
finance,
which
is
the
historical
returns
are
the
only
fact
pattern,
the
future
returns
are
your
opinion
and
my
opinion.
Particularly
in
that
process
of
migration
where
more
pools
of
capital
are
coming
in,
raising
the
valuations,
improving
the
returns,
you
can
look
like
a
fool-
a
complete
Cassandra-
arguing
that
this
is
bad
in
the
future
because
the
immediate
history
is
going
to
tell
you
the
exact
opposite.

JOSH
WOLFE:
And
the
analogies
between
the
history
in
public
markets,
which
I
try
to
study
a
lot-
not
anywhere
near
as
well
as
you.
I
learn
way
more
from
you
than
I
do
from
any
of
my
venture
brethren
when
it
comes
to
capital
markets.
And
you
compare
that
to
the
venture
world.
There
are
really
ends
of
ones
in
venture.
Like
looking
at
comparables,
in
1997,
you
would
have
been
an
idiot-
or
'98-
you
would
have
been
an
idiot
for
saying,
who
the
hell
needs
another
search
engine,
only
to
miss
Google.
But
then
once
you
see
the
presence
of
Google,
you
would've
been
an
idiot
to
try
to
fund
the
next
10
Lycoses
or
whatever
it
was.

And
so
it's
very
hard
because
you
have
these
aberrant
outcomes.
They
are
total
anomalies,
and
then
people
try
to
learn
from
these
things.
And
it's
just
it's
way
different.
And
I
would
actually
argue
that
the
reason
it's
different
is
because
you
do
not
have
the
kind
of
information
that
is
conveyed
through
price
discovery
in
traditional
markets.
You
do
not
have
the
number
of
really
smart
people
that
are
looking
at
a
security,
analyzing
its
history,
looking
at
the
fundamentals,
debating
it,
being
long
it,
being
short
it.
The
absence
of
that
kind
of
relative
efficiency
is
totally
missing
in
venture.

And
so
you
also
get,
which
you
don't
typically
get
in
the
public
markets
as
much,
massive
dislocations
between
bids
and
ask
in
pricing
events.
So
the
step-ups
that
we
see
in
seed
stage
round
can
be
10X
into
a
Series
A.
Now,
the
scale
of
what
you're
talking,
you
might
be
putting
a
few
$100,000,
or
a
few
million
dollars
in
it,
a
few
million
dollar
valuation,
and
then
you
might
be
raising
$20
or
$30
million
at
a
$50
million
valuation,
then
$100
million
at
$1
billion.
The
gaps-
the
discontinuities
between
those
is
huge.

Now,
liquidity
is
one
form
of
that-
this
sort
of
asymmetry
of
information,
but
it
starts
before
conception
or
inception
of
a
company.
And
there's
information
asymmetries
all
the
way.
And
you
could
argue
that
they
get
reduced
over
time.
But
the
first
information
asymmetry,
like
the
maximum
information
asymmetry,
is
with
the
invention
that
a
scientist
has.
And
there's
this
quote
from
Linus
Pauling,
a
Nobel
Laureate,
who
said,
I
know
something
that
nobody
else
in
the
world
knows.
And
they
won't
know
it
until
I
tell
them.
That
is
the
ultimate
power
in
the
world-
to
know
a
secret
that
soon,
the
rest
of
the
world
will
know,
but
you're
the
only
one
that
knows
it.
So
that's
maximum
information
asymmetry.

The
next
is,
okay,
now,
the
scientist
has
teamed
with
an
entrepreneur.
Now,
the
entrepreneur
might
have
asymmetry
because
not
a
lot
of
other
people
know
about
it
or
they've
befriended
the
scientist
and
they
started
the
company.
But
then
the
entrepreneur
has
an
asymmetry
of
both
a
false
positive
and
maybe
a
true
positive,
which
is
their
estimation
of
their
ability.
Almost
all
entrepreneurs
believe
that
they
are
more
valuable
than
the
market
thinks
they
are.
Because
if
the
market
thought
that
they
were-

JOSH
WOLFE:
And
by
the
way,
the
disposition
are
the
same.
They
throw
tantrums.
They
seem
like
they're
drunk.
You
don't
know
if
you
should
trust
them
with
money.
The
entrepreneur,
if
they
felt
fairly
valued
by
the
market,
would
go
and
just
join
a
consulting
firm-
a
McKinsey.
But
they
say,
no,
either
because
they
were
rejected,
and
they
say,
no,
I'm
going
to
go
do
it
myself.

And
so
to
do
something
entrepreneurial,
in
a
sense,
is
to
have
an
overestimation
of
the
thing
that
you
know
or
think
you
know
that
the
rest
of
the
world
doesn't.
Now
90%
roughly,
let's
just
say,
failure
means
that
10%
of
those
people
are
actually
right
or
lucky.
And
maybe
some
of
them
are
right
and
unlucky.
So
that's
the
next
asymmetry-
the
entrepreneur
who
thinks
that
they
know
something
or
maybe
does,
in
fact,
know
something
the
rest
of
the
world
doesn't.

Then
the
next
stage
is
the
investor.
So
now,
we
come
along
and
we
meet
the
engineer
or
the
Fred
Moll.
And
we
think,
okay,
wait
a
second.
We're
early
here.
We've
got
something
that
nobody
else
knows.
And
so
we
jump
on
that.
And
that's
really,
it
is
the
same
phenomenon
as
the
teenager
who
is
discovering
the
band
that
nobody
else
knows
about
yet-
the
book,
or
the
movie,
or
the
artist
that
is
going
to
impart
on
them
social
currency
because
they
have
discovered
the
thing
that
everybody
else
is
going
to
celebrate
later.
There's
no
difference.

So
for
us,
it
isn't
an
Excel
spreadsheet.
It's
not
a
model.
It's
like
based
on
the
market,
and
the
understanding
we
have,
and
the
marketability
of
this
entrepreneur,
and
their
ability
to
raise
money,
and
recruit
people
and
convince
them
to
part
with
their
jobs
and
move
across
the
country
and
join
them.
Do
we
think
that
these
guys
and
girls
are
going
to
be
really
valuable?
It's
a
total
qualitative
psychological
judgment.

So
now,
we're
in
the
first
few
board
meetings.
And
we
know
everything
that's
going
on
in
the
company,
or
let's
say,
80%
of
what's
going
on
in
the
company.
And
if
you
have
a
good
relationship
with
the
CEO,
you
know
a
lot
more.
And
if
you
don't,
then
they
hide
things
from
you.
But
now,
a
new
investor
comes
in.
And
so,
let's
say,
we've
invested
in
this
case,
like
in
Auris
a
$20
million
pre,
and
then
Peter
Thiel
comes
in
at
80
or
whatever
it
is.

Does
Peter
know
more
than
we
do?
Now,
maybe
he
knows
something
about
the
market
that
we
don't
know
or
maybe
he
has
an
unfair
access
to
be
able
to
make
introductions
that
are
going
to
create
value
by
reducing
risk.
But
there's
very
improbable
chance
that
a
new
investor
knows
more
about
what
is
happening
in
the
company
than
an
existing
investor.
So
now,
we
have
asymmetry
of
information.

And
so
it's
very
different
than
public
markets
where
you
might
have
different
preferences
in
time,
or
liquidity,
or
expected
return.
The
information
asymmetry
starting
from
that
scientist
to
the
entrepreneur
to
the
first
funders
to
the
later
funders
is
just
enormous.
Over
time,
I
think
it
starts
to
reduce.
And
then
ultimately,
you're
going
to
the
public
markets.
And
the
public
markets
are
saying,
well,
we
demand
to
be
able
to
look
at
the
books,
and
understand,
and
how
this
compares
to
comps,
and
how
it's
going
to
be
valued,
and
what
are
our
estimation
is
and
how
other
public
market
investors
are
going
to
value
it.

And
then
you
start
to
get
more
and
more
scrutiny.
And
scrutiny,
I
think
ultimately
creates
liquidity
and
it
creates
markets
because
you
have
more
information.
So
that
information
asymmetry
is
where
most
of
the
returns
on
venture
come
from,
and
being
able
to
identify
people
early,
develop
a
reputation
so
that
you
can
attract
the
next
entrepreneur
who
believes
that
they
might
be
like
your
last
entrepreneur,
and
have
a
reputation
for
being
a
good
actor
with
other
investors,
and
not
being
zero-sum
knowing
that
this
is
a
long
game.
And
otherwise,
I
think
it's
an
asset
class
that,
frustratingly
for
us
as
insiders
and
definitively
for
outsiders,
is
really
dominated
by
luck.